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Interest Rate Risk I Chapter 8


Interest Rate Risk I Chapter 8 Financial Institutions Management, 3/e By Anthony Saunders Central Bank and Interest Rate Risk Effects of interest rate targeting. – PowerPoint PPT presentation

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Title: Interest Rate Risk I Chapter 8

Interest Rate Risk I Chapter 8
  • Financial Institutions Management, 3/e
  • By Anthony Saunders

Central Bank and Interest Rate Risk
  • Effects of interest rate targeting.
  • Lessens interest rate risk
  • October 1979 to October 1982, nonborrowed
    reserves target regime.
  • Implications of return to reserves target policy
  • Increases importance of measuring and managing
    interest rate risk.

Repricing Model
  • Repricing or funding gap model based on book
  • Contrasts with market value-based maturity and
    duration models.
  • Rate sensitivity means time to repricing.
  • Repricing gap is the difference between the rate
    sensitivity of each asset and the rate
    sensitivity of each liability RSA - RSL.

Maturity Buckets
  • Commercial banks must report repricing gaps for
    assets and liabilities with maturities of
  • One day.
  • More than one day to three months.
  • More than 3 three months to six months.
  • More than six months to twelve months.
  • More than one year to five years.
  • Over five years.

Repricing Gap Example
  • Assets Liabilities Gap Cum. Gap
  • 1-day 20 30 -10 -10
  • gt1day-3mos. 30 40
    -10 -20
  • gt3mos.-6mos. 70 85
    -15 -35
  • gt6mos.-12mos. 90 70
    20 -15
  • gt1yr.-5yrs. 40 30
    10 -5
  • gt5 years 10 5
    5 0

Applying the Repricing Model
  • DNIIi (GAPi) DRi (RSAi - RSLi) Dri
  • Example In the one day bucket, gap is -10
    million. If rates rise by 1,
  • DNIIi (-10 million) .01 -100,000.
  • Example II If we consider the cumulative 1-year
  • DNIIi (CGAPi) DRi (-15 million)(.01)
  • -150,000.

Rate-Sensitive Assets
  • Examples from hypothetical balance sheet
  • Short-term consumer loans. If repriced at
    year-end, would just make one-year cutoff.
  • Three-month T-bills repriced on maturity every 3
  • Six-month T-notes repriced on maturity every 6
  • 30-year floating-rate mortgages repriced (rate
    reset) every 9 months.

Rate-Sensitive Liabilities
  • RSLs bucketed in same manner as RSAs.
  • Demand deposits and passbook savings accounts
    warrant special mention.
  • Generally considered rate-insensitive, but there
    are arguments for their inclusion as
    rate-sensitive liabilities.

CGAP Ratio
  • May be useful to express CGAP in ratio form as,
  • CGAP/Assets.
  • Provides direction of exposure and
  • Scale of the exposure.

Weaknesses of Repricing Model
  • Weaknesses
  • Ignores market value effects
  • Overaggregative
  • Distribution of assets liabilities within
    individual buckets is not considered. Mismatches
    within buckets can be substantial.
  • Ignores effects of runoffs
  • Bank continuously originates and retires consumer
    and mortgage loans. Runoffs may be rate-sensitive.

The Maturity Model
  • Explicitly incorporates market value effects.
  • For fixed-income assets and liabilities
  • Rise (fall) in interest rates leads to fall
    (rise) in market price.
  • The longer the maturity, the greater the effect
    of interest rate changes on market price.
  • Fall in value of longer-term securities increases
    at diminishing rate for given increase in
    interest rates.

Maturity of Portfolio
  • Maturity of portfolio of assets (liabilities)
    equals weighted average of maturities of
    individual components of the portfolio.
  • Principles stated on previous slide apply to
    portfolio as well as to individual assets or
  • Typically, MA - ML gt 0 for most banks and thrifts.

Effects of Interest Rate Changes
  • Size of the gap determines the size of interest
    rate change that would drive net worth to zero.
  • Immunization and effect of setting
  • MA - ML 0.

Maturity Matching and Interest Rate Exposure
  • If MA - ML 0, is the FI immunized?
  • Extreme example Suppose liabilities consist of
    1-year zero coupon bond with face value 100.
    Assets consist of 1-year loan, which pays back
    99.99 shortly after origination, and 1 at the
    end of the year. Both have maturities of 1 year.
  • Not immunized, although maturities are equal.
  • Reason Differences in duration.

Term Structure of Interest Rates
  • YTM

Time to Maturity
Time to Maturity
Time to Maturity
Time to Maturity
Unbiased Expectations Theory
  • Yield curve reflects markets expectations of
    future short-term rates.
  • Long-term rates are geometric average of current
    and expected short-term rates.
  • _ _
  • RN (1R1)(1E(r2))(1E(rN))1/N - 1

Liquidity Premium Theory
  • Allows for future uncertainty.
  • Premium required to hold long-term.
  • Market Segmentation Theory
  • Investors have specific needs in terms of
  • Yield curve reflects intersection of demand and
    supply of individual maturities.